A number of firms, such as BCE Inc., Coca-Cola, and McDonalds, have discontinued their practice of issuing quarterly earnings forecasts, thereby lowering their disclosure quality. The reason usually given is that the severe negative consequences of not meeting quarterly targets gives management a short-run focus, distracting it from the attainment of longer- term goals Consequently, the firm is better off not to issue a forecast in the first place. For example, in a 2005 speech to Wall Street analysts, Thomas Donohue, head of the US. Chamber of Commerce, stated "companies sacrifice creating long-term value if it means missing quarterly earnings projections. Some managers forgo making investments and cut expenditures on R&D and marketing to ensure that they hit quarterly numbers, even if they believe that the cuts are destroying business value over the long term.

" Others disagree In a 2003 speech, Sheryl Kennedy, deputy governor for financial markets of the Bank of Canada, encouraged firms to increase their forecasting, arguing that corporations should provide quarterly outlooks so that investors could better value companies. She did not say specifically that such forecasting should be in the form of earnings forecasts (MD&A, which does not specifically require earnings forecasts, provides an alternative vehicle for forward-looking disclosures, for example). Nevertheless, her arguments suggest that the market would not look favorably on discontinuance of earnings forecasts In this regard, another reason can be suggested to explain why firms may discontinue forecasts, namely, to disquise poor performance. Chen, Matsumoto, and Rajgopal (2006) analyzed a sample of 76 firms that discontinued forecasting of quarterly earnings during 2001-2004. They found that the average stock market return on the shares of these firms for the year prior to discontinuance was significantly less than the return on the shares of a control sample of similar firms that had not discontinued forecasting. The discontinuing firms also had a higher proportion of prior loss quarters, and a higher proportion of quarters for which earnings were less than the same quarter of the preceding year (recall that earnings of the prior year's quarter is a proxy for expected earnings of the current quarter) All of these findings are consistent with relatively poor performance for the discontinuing firms. The stock market seems to agree with this latter reason. Chen, Matsumoto, and Rajgopal reported a negative stock market return for the sample firms over a three-day window surrounding the date of announcement of forecast discontinuance, suggesting that investors revised downwards their probabilities of good future performance. The researchers also report some evidence that the betas of the sample firms increased follow- ing their announcements, suggesting an increase in cost of capital. If the main reason for discontinuance of quarterly earnings forecasts was that this created management distrac- tion from longer-term goals, we would expect the market to react positively to the announcements, rather than negatively

Required

a. Outline some of the costs to firms of issuing quarterly earnings forecasts.

b. Outline some of the benefits to firms of issuing quarterly earnings forecasts.

c. Why does the market penalize the share price of firms that do not meet their earnings targets? include in your answer an explanation of why the disclosure principle has not motivated these firms to continue their forecasts.

d. Why would managers forgo capital investments, and cut R&D and marketing costs, in order to meet earnings targets, rather than meeting earnings targets by means of Income-increasing discretionary accruals? Explain